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Today's revision to second quarter GDP brought with it our first look at corporate profits, and they were once again very strong, if not fairly spectacular. Not only were after-tax profits up over 9% relative to a year ago, corporate profits are now at an all-time record high of 10.1% relative to GDP. We've never seen anything like this.

So the question that absolutely begs to be answered is this: Why haven't equity prices kept pace with the huge increase in corporate profits? After-tax corporate profits averaged $554 billion in 2000, and the S&P 500 index averaged 1423 that year. Now corporate profits have soared by 173%, but equity prices have fallen by over 17%. Hold on, you say, it's obvious that equity prices were in a bubble in 2000. Ok, so let's go back to 1995 for purposes of comparison. In 1995 the PE ratio of the S&P 500 was 16.5, about equal to its long-term average, and the index averaged about 550 that year while after-tax corporate profits averaged about $500 billion. So in the past 16 years, corporate profits have tripled, while the S&P 500 has only slightly more than doubled. There's no getting around the fact that equity prices have seriously lagged the performance of corporate profits.

And if you consider that interest rates have collapsed in the past 16 years (the 10-yr Treasury yield averaged 6.5% in 1995, and now it stands at 2.2%), then the lagging performance of equities becomes even more amazing. If the value of equities is a function of the discounted present value of future after-tax profits, then a huge decline in the discount rate ought to result in at least some rise in PE multiples, shouldn't it? But the PE of the S&P 500 today is less than 13, about 30% less than it was in 1995.

I've done this analysis every quarter for the past several years, and each time I conclude that the only logical explanation for why stocks are lagging profits is that the market expects a) interest rates to rise and/or b) profits to decline in future years. So far, neither have happened; in fact, interest rates have fallen and profits have continued to rise. Maybe the market has just been looking way ahead to events that have not yet happened, or maybe the market is just way too pessimistic. But one thing is clear: it's difficult if not impossible to find even a shred of optimism in today's equity valuations.

Here's another way of looking at this. The chart above represents the PE ratio of all corporate equities, using a normalized S&P 500 index as a proxy for the "P" and the National Income and Product Accounts tally of after-tax corporate profits as the "E." PE ratios by this measure are about 10, significantly below their long-term average of 15.6. Stocks are very cheap by historical standards, and the last time they were this cheap, in the late 1970s and early 1980s, was an excellent time to invest from a long-term investor's perspective. Skeptics would counter by saying that this time is different, because 1) politicians are incapable of spending restraint, so taxes are going to rise significantly, 2) the economy is going to be miserable for the foreseeable future, pushing profits way down, and 3) the Fed's super-accommodative monetary policy is going to push inflation and interest rates much higher. Maybe so, but that's about what it would take to justify the current level of prices.

Bottom line: you have to be very pessimistic about the future in order to not like equity valuations today.